Herb Smith, the tax partner, has just talked to you about one of his clients, John Barwell.

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Question:

Herb Smith, the tax partner, has just talked to you about one of his clients, John Barwell. John has owned his retail store, Aurora Collectibles, for the past four years. Despite a recession, he has been able to do very well with the store by offering customers decorating advice along with the antiques and other unusual items that he sells. Last year, his store earned net income of $325,000.

When he first started the business, he set it up as a proprietorship and financed it with a loan of $200,000 from his wife, Alison, and a $175,000 bank operating loan. Currently, both of the loans remain unpaid, since both John and Alison enjoy a lifestyle that uses up all of their cash flow. Both John and Alison agree that they are going to improve their spending habits. They want John to pay off the bank operating loan from the business earnings.

Once this is done, any excess cash will be used by John to invest in some property that they will eventually move the store into. Alison isn’t involved in the retail store business.
Herb wants you to identify the tax issues and tell him what analysis you propose to do to help John and Alison. He doesn’t want you to get into the numbers yet.